Financial innovation can do a lot of good, says Andrew Palmer. It is its tendency to excess that must be curbed – Published on The Economist, February 25, 2012.

… Peterborough is where the proceeds of the world’s first “social-impact bond” are being spent. This instrument is not really a bond at all but behaves more like equity. In September 2010 an organisation called Social Finance raised £5m ($7.8m) from 17 investors, both individuals and charities. The money is being used to pay for a programme to help prevent ex-prisoners in Peterborough from reoffending.

Reconviction rates among the prisoners recruited to the scheme will be measured against a national database of prisoners with a similar profile, and investors will get payouts from the Ministry of Justice if the Peterborough cohort does better than the rest. If all goes well, the first payouts will be made in 2013.

The scheme is getting lots of attention, and not just in Britain. A mixture of social and financial returns is central to a burgeoning asset class known as “impact investing”. Linking payouts to outcomes is attractive to governments keen to husband scarce resources. And if service providers like the people running the Peterborough prisoner-rehabilitation scheme can get a lump sum up front, they can plan ahead without bearing any financial risk. There is talk of introducing social-impact bonds in Australia, Canada and the United States.

Here, surely, is a financial innovation that even the industry’s critics would agree is worth trying. Yet in fundamental ways an ostensibly “good” instrument like a social-impact bond is not so different from its despised cousins. First, at its root the social-impact bond is about creating a set of cashflows to suit the needs of the sponsor, the provider and the investor. True, the investors in the Peterborough scheme may be more willing than the average individual or pension fund to sacrifice financial returns for social benefits. But as Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, a think-tank, argue in their useful book, “Financing the Future”, the thread that runs through much wholesale financial innovation is the creation of new capital structures that align the interests of lots of different parties.

Second, the social-impact bond is based on the concept of risk transfer, in this case from the government to financial investors who will get paid only if the scheme is successful. Risk transfer is also one of the big ideas behind securitisation, the bundling of the cashflows from mortgages and other types of debt on lenders’ books into a single security that can be sold to capital-markets investors. The credit-default swap is an even simpler risk-transfer instrument: you pay someone else an insurance premium to take on the risk that a borrower will default.

Third, even at this early stage the social-impact bond is grappling with the difficulties of measurement and standardisation. An obvious example is the need to create defined sets of measurements in order to work out what triggers a payout—in this case, the comparison between the Peterborough prisoners and a control group of other prisoners in a national database. Across finance, standardisation—around contracts, reporting, performance measures and the like—is what enables buyers and sellers to come together quickly and new markets to take off.

Neither angels nor demons: … //

… Greed is bad:

There is an easy answer: people. When bubbles froth, greedy folk use innovations inappropriately—to take on exposures that they should not, to manufacture risk rather than transfer it, to add complexity in order to plump up margins rather than solve problems. But in those circumstances old-fashioned finance goes mad, too: for every securitisation stuffed with subprime loans in America, there was a stinking property loan sitting on the balance-sheet of an Irish bank or a Spanish caja. “Duff credit analysis is always the cause of the problem,” says Simon Gleeson of Clifford Chance, a law firm.

This argument has a lot of power. When greed takes hold, finance in all its forms is undone. Yet blaming the worst outcomes of financial innovation on human frailty is hardly helpful. This special report will point to the features of financial innovations that can turn them into troublemakers over time and show how these can be managed better.

In simple terms, finance lacks an “off” button. First, the industry has a habit of experimenting ceaselessly as it seeks to build on existing techniques and products to create new ones (what Robert Merton, an economist, termed the “innovation spiral”). Innovations in finance—unlike, say, a drug that has gone through a rigorous approval process before coming to market—are continually mutating. Second, there is a strong desire to standardise products so that markets can deepen, which often accelerates the rate of adoption beyond the capacity of the back office and the regulators to keep up.

As innovations become more and more successful, they start to become systemically significant. In finance, that is automatically worrying, because the consequences of any failure can ripple so widely and unpredictably. In a 2011 paper for the National Bureau of Economic Research, Josh Lerner of Harvard Business School and Peter Tufano of Said Business School also argue that in a typical “S-curve” pattern, in which the earliest adopters of an innovation are the most knowledgeable, a widely adopted product is more likely to have lots of users with an inadequate grasp of the product’s risks. And that can be a big problem when things turn out to be less safe than expected. (full long text).